Like a number of states, New York requires nonresidents to pay income taxes on wages earned in the state. Those rules extend to an allocable portion of deferred compensation and gain from the exercise of stock options earned while employed in the state. The state’s ability to tax a nonresident is limited to this extent: Federal law prohibits states from taxing nonresidents on distributions from qualified retirement plans or on distributions of nonqualified deferred compensation paid in installments over the recipient’s life expectancy or over a period of at least ten years.
A recent decision of the New York State Division of Tax Appeals upheld the determination of the New York Division of Taxation that a nonresident retiree had to allocate to New York a portion of the income he realized from exercising stock options and from receipt of deferred compensation after his retirement. The individual was a resident of Connecticut while he was employed by American Airlines and after his retirement. During his employment, he worked both within and without New York. He received stock options during the years 1996 through 2001 and again in 2003. He retired in 2005 at which time the options were in the aggregate underwater. He then exercised the stock options during 2006.
The state of New York allocated the stock option gain based upon the number of days worked in New York between the date of grant and the date of retirement, resulting in approximately two-thirds of the gain being allocated to New York. The state used the same allocation for the deferred compensation. The retiree challenged the allocation on various grounds, including that regulations describing the method of allocation were unfair and unworkable for nonresidents. The Division of Tax Appeals upheld both the regulations and the allocation of the income to New York.
Other states have similar requirements to allocate stock option gain and deferred compensation to the state where an employee worked during the time that options were granted and vested and that deferred compensation was earned. Minnesota, where I practice, is one such state. Sometimes those states look to judicial decisions in states with similar allocation provisions. This case from New York may be used by a state like Minnesota to support its laws mandating allocation of stock option gains and deferred compensation earned by an employee in Minnesota who receives the benefits after moving from the state.
Employees who move to a state without an income tax before exercising options or taking receipt of deferred compensation may be surprised to find that all or a portion of that income remains subject to taxation by the state where they worked during their careers. This New York decision shows that the states are able to collect taxes in that situation.